The Pro Guide to Shorting

There's more risk than potential gain, so tread carefully.

The following is adapted from an article originally written for our Motley Fool Pro investing service. Look at the end of the article for more information about this new service.

Short-sellers often get a bad rap in the investing world. When the market is up, they're chastised for holding back the rally. When the market is down, they're reviled for keeping it "artificially low." And when the majority of long-term investors are hurting, that's exactly when successful short-sellers profit most.

For instance, against-the-grain hedge fund managers such as Manuel Asensio, who shorted tech stocks before the dot-com crash, or John Paulson, who shorted the ABX subprime index before the housing bubble collapsed, made big profits from shorting. Yet while short-selling can pay off, the strategy is risky -- so it's imperative that you understand how this strategy works before diving in.

What is a short?A short sale is a way to profit when stock prices decline. Here's how it works: First, you borrow from your broker shares of a stock that you think is overvalued. Your broker immediately sells those shares on the market, and the money from the sale is lent to your account (since you didn't actually own the shares you sold). Later, you replace the borrowed shares (buy them back) at a lower price -- ideally! -- and keep the difference as a profit.

Say, for example, Stock XYZ is trading at $100, but you believe it's worth no more than $50. You borrow 100 shares and sell them at $100 each for a total of $10,000. A few months later, huzzah! You were right: Stock XYZ falls to $50, and you can buy back the 100 shares for just $5,000. You keep the remaining $5,000 (minus commissions and interest on the "loan") and do a happy dance.

It may sound simple, but this strategy can bite you if you don't get it right. Using the same example, let's say those 100 shares of Stock XYZ skyrocket to $300. Ouch! If you want out of your short sale at that point, you'll need to pay $30,000 to close the trade -- so you've lost $20,000 plus commissions and interest.

So while the maximum gain you can take from a short sale is 100% -- that is, the stock goes to $0 -- the maximum loss is theoretically infinite. Take a look at the returns you would have earned by shorting these stocks five years ago:

Stock

Price in 2003

Current Price

Short Return

General Motors(NYSE:GM)

44.07

3.60

91.8%

AIG(NYSE:AIG)

62.33

1.55

97.5%

Citigroup(NYSE:C)

39.13

6.57

83.2%

American Express(NYSE:AXP)

40.21

17.70

56.0%

ConocoPhillips(NYSE:COP)

28.91

49.00

(69.5%)

PotashCorp(NYSE:POT)

13.90

73.22

(426.8%)

Apple(NASDAQ:AAPL)

10.57

86.61

(719.4%)

Source: Yahoo! Finance.

Using a strategy that has more risk than potential gain means you must be very careful -- and have an iron stomach.

How do I short a stock?To short a stock -- and this applies only to stocks, not ETFs -- go to your broker site (make sure you're set up for a margin account, which lets you borrow shares), enter the ticker, and use the command "sell to open" or "sell short." If your stock is available for shorting -- not all are -- when you make the trade, you'll see a lent payment, as a negative number, in your account. If the stock goes down, you can buy it back any time with the command "buy to close" at the lower share price. The difference is your profit.

If the stock price increases, you'll eventually need to buy it back at the higher price and suffer the loss, so make sure you have cash to cover this possibility. Theoretically, you could wait for years, in hopes that the stock comes back down -- but your losses could continue to grow, and you could be wiped out. In most cases, selling short is a short-term strategy measured in months rather than years.

Strings attachedThere are a few sticky issues to keep in mind with shorts: First, you need to cough up any dividends while you borrow the shares. Second, you'll be paying interest on the loan you've taken to borrow the shares, so you need to factor that into your bottom-line projections. Finally, you could be given the short squeeze: If your stock price goes up, your broker can force you out of your short position if it needs to deliver the shares back to the owner.

The bottom lineDespite their unpopularity, investors who short stocks see themselves as a necessary element to keep the market healthy. By researching companies with extreme due diligence and digging deep for flaws, investors on the short side improve the quality of information available in the market while exposing companies as weak.

But finding the right companies to short, buy puts on, or short with ETFs is a challenge because the market's historical long-term trend is upward. So you'll want to focus on companies with burdensome debt loads, low profits, few competitive advantages, questionable management, and, most important, companies that are overvalued. To win with shorting, you want to find shorts with limited upside risk and large downside potential -- the exact opposite of what you want when buying a stock.

This article is adapted from an article by Jeff Fischer for our Motley Fool Pro service. It has been updated by Dan Caplinger, who doesn't own shares of the companies mentioned.

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